**1. Introduction**

Climate change is the disruption in the long-term seasonal weather patterns caused by global warming. How will long-term climate change affect businesses and the financial system, and how should impacts be managed over the course of the twenty-first century? These are some of the questions that have gained unprecedented attention in public discourse as global warming projections for the coming decades get worse.

Climate change exacerbates existing risks and creates new risks for natural and human systems [1]. The World Economic Forum's Global Risk Report specifies that three of the five topmost likely global risks are related to climate change. Specifically, it ranks failure of climate change mitigation and adaptation as the one most likely to impact on global risk [2]. *The adverse effects of climate change are pervasive and systemic, affecting* all asset classes, industries, and economies, and in turn, the financial system.

The bankruptcy of California's largest electric utility, Pacific Gas and Electric (PG and E), dubbed the first climate change bankruptcy [3], demonstrates the possible disruptions of production and consumption, and reduction in future asset values from impacts of climate change [4]. Notably, Mark Carney, the former governor of the Bank of England, has linked climate-related risks to financial stability. He noted that the combination of the weight of scientific evidence and the dynamics of the financial system suggest that in the fullness of time, climate change will threaten financial stability and longer-term prosperity [5].

From the foregoing that climate change has developed to one of the greatest global challenges, it is imperative to examine the climate change science and uncertainties associated with climate change, while identifying and explaining climaterelated risks, the financial aspect of climate change, credit implications of climate change, integration of climate-related risks into credit risk assessment, and climate risk management.

The main aim of the chapter is to enumerate the channels through which climate change can cause credit risks and affect the stability of the financial system. Approaches to incorporate climate change into corporate risk management are also discussed. The chapter employs a systematic literature review approach to explore the relationship between the three notions of climate-related risks, credit risk, and financial stability toward achieving its objectives.

The rest of the chapter is divided into seven parts. Section 2 discusses the science and uncertainties involved in climate change. While various forms of climate-related risks are presented in Section 3, Section 4 enumerates their credit risk implications. How to integrate climate-related risks into credit risk assessment is the focus of Section 5. Sections 6 and 7 explore how climate change can negatively impact financial stability and how organizations could manage climate-related risks, respectively. Section 8 presents the findings and makes suggestions for further research.

### **2. Scientific uncertainty and climate change**

Since Arrhenius [6] established and quantified the contribution of carbon dioxide (CO2) to climate change, the consensus among publishing scientists, international agencies, and leading scientific societies in climate science is that the increase in the earth's temperature we are currently witnessing is anthropogenic, that is man-made [1, 7, 8] caused by the release of greenhouse gases (GHGs) into the atmosphere. The most prevalent of these GHGs is carbon dioxide (CO2), associated with burning fossil fuels, industrial processes, forestry, and other land uses, but other gases—such as methane (CH4) and nitrous oxide (N2O)—are also contributing [9].

The decay rate of GHG in the atmosphere alters as the average temperature level increases. There has been a striking rise in temperatures over the last decade as the level of CO2 in the atmosphere has skyrocketed. Global temperatures have been far higher in the past decade compared with their 100-year average, in tandem with an unprecedented rise in CO2 in the atmosphere as shown in **Figure 1**.

Scientific advances that allow long-dated horizons suggest that irrevocable temperature increases have already been locked in (see **Figure 2**). Moreover, the current trends are on track to lead to systemic disruptions to ecosystems, societies, and economies [12] and may be catastrophic and irreversible for human populations, according to more than 11,000 scientists [13].

While the future is always unknown, we speak of risk if the probability distribution of possible future outcomes is known and of uncertainty if it is not. Humaninduced climate change, its impacts, mitigation, and adaptation are fraught with uncertainty. The future pathways for GHG emissions and temperatures set out by climate scientists embody both risk and uncertainty.

The uncertainties involved in climate change preclude prediction of the precise nature, timing, frequency, intensity, and location of climate change impacts. These uncertainties also depend on a multitude of demographic and socioeconomic factors, such as technology, values and preferences, and policies, which are also deeply uncertain [14]. Added to these demographic and socioeconomic sources of uncertainty is scientific uncertainty which arises from our incomplete knowledge of the climate system [15].

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**Figure 2.**

*year) [11].*

**Figure 1.**

*Climate Change, Credit Risk and Financial Stability DOI: http://dx.doi.org/10.5772/intechopen.93304*

Due to these interacting sources of uncertainty, studies of climate change and its impacts rarely yield consensus on the distribution of exposure, vulnerability, or possible outcomes. Thus, in contrast to risk situations where the probability distributions are known, there are no well-defined probability density functions (which are among the most common tools for characterizing uncertainty) for climate change [16]. Climate uncertainty leads to imprecision in estimating climate and economic outcomes. This implies not only imperfect understanding of the ability of mitigation pathways to deliver temperature outcomes but also suggests that there is a significant possibility that the tails of the distribution are considerably fatter than currently estimated. Fat-tailed climate events could not only significantly damage

*Climate risk scenarios: Projections of carbon emissions and global warming (emissions of CO2 in gigatons per* 

*Atmospheric carbon dioxide and Earth's surface temperature (1880–2019) [10]. Yearly temperature compared to the twentieth-century average (red and blue bars) from 1880 to 2019, based on the data from National Oceanic and Atmospheric Administration's National Centers for Environmental Information (NOAA NCEI), plus atmospheric carbon dioxide concentrations (gray line): 1880–1958 from Institute for Atmospheric and Climate Science (IAC), 1959–2019 from NOAA Earth System Research Laboratories. Original graph by Dr. Howard* 

*diamond NOAA Air Resources Laboratory, and adapted by NOAA Climate.gov.*

#### **Figure 1.**

*Banking and Finance*

risk management.

From the foregoing that climate change has developed to one of the greatest global challenges, it is imperative to examine the climate change science and uncertainties associated with climate change, while identifying and explaining climaterelated risks, the financial aspect of climate change, credit implications of climate change, integration of climate-related risks into credit risk assessment, and climate

The main aim of the chapter is to enumerate the channels through which climate change can cause credit risks and affect the stability of the financial system. Approaches to incorporate climate change into corporate risk management are also discussed. The chapter employs a systematic literature review approach to explore the relationship between the three notions of climate-related risks, credit risk, and

The rest of the chapter is divided into seven parts. Section 2 discusses the science and uncertainties involved in climate change. While various forms of climate-related risks are presented in Section 3, Section 4 enumerates their credit risk implications. How to integrate climate-related risks into credit risk assessment is the focus of Section 5. Sections 6 and 7 explore how climate change can negatively impact financial stability and how organizations could manage climate-related risks, respectively. Section 8 presents the findings and makes suggestions for further research.

Since Arrhenius [6] established and quantified the contribution of carbon dioxide (CO2) to climate change, the consensus among publishing scientists, international agencies, and leading scientific societies in climate science is that the increase in the earth's temperature we are currently witnessing is anthropogenic, that is man-made [1, 7, 8] caused by the release of greenhouse gases (GHGs) into the atmosphere. The most prevalent of these GHGs is carbon dioxide (CO2), associated with burning fossil fuels, industrial processes, forestry, and other land uses, but other gases—such

The decay rate of GHG in the atmosphere alters as the average temperature level increases. There has been a striking rise in temperatures over the last decade as the level of CO2 in the atmosphere has skyrocketed. Global temperatures have been far higher in the past decade compared with their 100-year average, in tandem with an

Scientific advances that allow long-dated horizons suggest that irrevocable temperature increases have already been locked in (see **Figure 2**). Moreover, the current trends are on track to lead to systemic disruptions to ecosystems, societies, and economies [12] and may be catastrophic and irreversible for human popula-

While the future is always unknown, we speak of risk if the probability distribution of possible future outcomes is known and of uncertainty if it is not. Humaninduced climate change, its impacts, mitigation, and adaptation are fraught with uncertainty. The future pathways for GHG emissions and temperatures set out by

The uncertainties involved in climate change preclude prediction of the precise nature, timing, frequency, intensity, and location of climate change impacts. These uncertainties also depend on a multitude of demographic and socioeconomic factors, such as technology, values and preferences, and policies, which are also deeply uncertain [14]. Added to these demographic and socioeconomic sources of uncertainty is scientific uncertainty which arises from our incomplete

as methane (CH4) and nitrous oxide (N2O)—are also contributing [9].

unprecedented rise in CO2 in the atmosphere as shown in **Figure 1**.

tions, according to more than 11,000 scientists [13].

climate scientists embody both risk and uncertainty.

knowledge of the climate system [15].

financial stability toward achieving its objectives.

**2. Scientific uncertainty and climate change**

**76**

*Atmospheric carbon dioxide and Earth's surface temperature (1880–2019) [10]. Yearly temperature compared to the twentieth-century average (red and blue bars) from 1880 to 2019, based on the data from National Oceanic and Atmospheric Administration's National Centers for Environmental Information (NOAA NCEI), plus atmospheric carbon dioxide concentrations (gray line): 1880–1958 from Institute for Atmospheric and Climate Science (IAC), 1959–2019 from NOAA Earth System Research Laboratories. Original graph by Dr. Howard diamond NOAA Air Resources Laboratory, and adapted by NOAA Climate.gov.*

#### **Figure 2.**

*Climate risk scenarios: Projections of carbon emissions and global warming (emissions of CO2 in gigatons per year) [11].*

Due to these interacting sources of uncertainty, studies of climate change and its impacts rarely yield consensus on the distribution of exposure, vulnerability, or possible outcomes. Thus, in contrast to risk situations where the probability distributions are known, there are no well-defined probability density functions (which are among the most common tools for characterizing uncertainty) for climate change [16].

Climate uncertainty leads to imprecision in estimating climate and economic outcomes. This implies not only imperfect understanding of the ability of mitigation pathways to deliver temperature outcomes but also suggests that there is a significant possibility that the tails of the distribution are considerably fatter than currently estimated. Fat-tailed climate events could not only significantly damage growth and welfare, but economic mechanisms may also be ineffective in responding appropriately. This could result in structural economic changes, and banks may find themselves facing abrupt adjustment which could be severely financially disruptive [17].
